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Chapter 33, Part I. Risk Management Framework. Page 9

Discussion in 'Complete Trading Education- Forex Military School' started by Sive Morten, Dec 28, 2013.

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  1. Sive Morten

    Sive Morten Special Consultant to the FPA

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    Couple of words about Reward/Risk ratio


    Commander in Pips: Here is another issue that lets you understand why a trading journal and statistical numbers are important. In fact, Reward/Risk ratio is a relationship between your potential loss and potential profit in each trade. For example, if you’ve placed stop loss to 50 pips, while your profit has placed at 100 pips, then your Reward/Risk ratio is 2:1 or simply 2. Now, let’s understand why statistics are so important here - mostly because there is a balance between your system's effective strength and your reward/risk ratio. For example, if your trading system shows 50% of profitable trades, that your reward/risk ratio should be greater than 1. Otherwise you will stand at or below breakeven and will not earn anything. On following table we will show edge reward/risk ratios depending on your system % Win trades ratio:

    % Won Trades Minimum Reward/Risk Ratio for Every Trade
    10 must be greater than 9:1
    20 must be greater than 4:1
    30 must be greater than 2.3:1
    40 must be greater than 1.5:1
    50 must be greater than 1:1
    60 must be greater than 0.67:1
    70 must be greater than 0.43:1
    80 must be greater than 0.25:1
    90 must be greater than 0.11:1

    This is very simple to understand. For instance, if you win just in a single trade from ten possible, you have to earn so, that compensate all loss in other 9 trades and get some profit. So you have to earn, say, at least 100 pips in 1 trade and lose no more than 90 pips in the 9 rest.

    Actually, although we’ve pointed out that if you have super efficient system with 90 % winning trades you can let yourself to use just 0.1 reward/risk ratio – this is not wise. Statistically yes, you will earn profit, but logically there is no sense to take Reward/risk ratio less than 1 in any trade. A ratio of less than 1 skewed chances of success against you with many repetitions of such trades. A trader’s major task is to increase probability of success in any trade. That’s why he/she should not apply Reward/risk ratio less than 1 in any trade. Usually it is recommended to apply a 2:1 or even 3:1 ratio, but we have to point out that this is not a hard-rock ratio that could not be changed. If you will base your trades on a constant ratio this will lead to some problems – your targets could be too far, relative to what analysis tells you, you will trade too big of lots, or place too tight of stop-loss orders. Reward/risk ratio is a consequence but not the reason.
     
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